I am a senior editor at Forbes, covering legal affairs, corporate finance, macroeconomics and the occasional sailing story. I was the Southwest Bureau manager for Forbes in Houston from 1999 to 2003, when I returned home to Connecticut for a Knight fellowship at Yale Law School. Before that I worked for Bloomberg Business News in Houston and the late, great Dallas Times Herald and Houston Post. While I am a Chartered Financial Analyst and have a year of law school under my belt, most of what I know about financial journalism, I learned in Texas.

A Brief Explanation Of The Economics Of Securities Lawsuits

I’m not trying to make this the Ted Frank channel, and clearly the audience for articles about securities class actions is extremely limited. (See: the story immediately below this one.) However, Frank, who runs the Center for Class Action Fairness, has filed an objection to the $67.5 million settlement of a shareholder suit against Wyeth that contains one of the clearest explanations of the economics of this type of litigation I have seen.

Frank represents an investor who objects to the $16.5 million fee Robbins Geller is seeking for negotiating the settlement with Wyeth, which would consume a quarter of the settlement and represents a multiple of more than four times the amount the firm claims to have invested in the case (which likely includes a hefty markup already).

These so-called “lodestar” multiples are intended to compensate lawyers for rolling the dice on risky lawsuits they might otherwise not bring. Judges don’t seem to question the logic behind this, and neither do they seem to have a grasp of portfolio theory. For big firms like Robbins Geller don’t just gamble on one lawsuit, they have 10 or 20 of them pending at any time and stand an excellent chance of collecting on nearly all of them.

That’s thanks to another rule embedded in the Private Securities Litigation Act, which governs securities class actions and gives plaintiff lawyers the equivalent of a peek at the dealer’s cards before they raise their bets in the poker game. It allows for a “discovery stay” until both sides learn whether the defense has won its motion to dismiss. Cornerstone Research’s 2011 report shows the enormous importance of this provision: Of 2,400 cases filed and resolved between 1996 and 2011, 57% settled. But 82% of the 1,000 or so cases that survived a motion to dismiss settled.

As Frank explains:

Thanks to the discovery stay, it is easy for PSLRA attorneys to act like hedge-fund managers or like card-counters in blackjack. The motion to dismiss is risky, but the plaintiffs’ attorneys can devote relatively small bets and investments to the early part of the case. If they lose the motion to dismiss, the loss is pretty small. But once they survive the motion to dismiss, the odds are better than 4:1 in their favor on average, and they can load up the lodestar with as much discovery as the other side will tolerate. Moreover, plaintiffs’ attorneys can pick and choose which cases to put resources into, and will naturally choose the cases that are more likely to have a large settlement—just like a blackjack player will double down on an 11, but not on a 12. Thus, it is very rare for PSLRA attorneys to devote tens of thousands of hours to a case and be unable to settle for an amount that pays their lodestar in full. The decision to invest an hour of an attorney’s time is made on an ongoing basis as the case continues—and the decision to invest time is considerably less risky after a motion to dismiss is resolved favorably than before. If class counsel is required to disclose how much lodestar they spend on securities cases before a motion to dismiss is decided and how much lodestar is spent after a motion to dismiss was denied, the Court will see a stark difference: in most cases settled after a motion to dismiss is resolved favorably, most of the hours in the case will have been devoted well after most of the risk of not settling had passed.

Judges should pay more attention to this analysis, since they base their generous fee awards upon the theory that firms like Robbins Geller need a rich multiple to continue the valuable work of suing corporations. Not only are the plaintiff lawyers’ estimates of what they have invested in the case inflated by the use of low-paid associates and contract attorneys, but the economic assumption behind the multiples is flawed.

Shareholders should care about this, even if the lead plaintiff, the City of Livonia, Mich. does not. (The city west of Detroit has sued Boeing, Wachovia and at least five other companies in the last three years.) As I have observed many times before, securities settlements are paid by shareholders and every dollar that flows to the lawyers is a dollar they no longer own. Yes some of the money flows to former shareholders, but in big, liquid stocks those former shareholders are also likely to be current shareholders. Perhaps they could enjoy the same level of service from plaintiff attorneys they are now getting with lower fees. Only if judges learn a little more about economics will they find out.

Post Your Comment

Post Your Reply

Forbes writers have the ability to call out member comments they find particularly interesting. Called-out comments are highlighted across the Forbes network. You'll be notified if your comment is called out.